Final answer:
To reduce inflationary potential in an economy, policymakers would avoid increasing the budget deficit, as such a move could raise aggregate demand, further fueling inflation. Instead, contractionary fiscal policies such as tax increases can help decrease aggregate demand and tackle inflation.
Step-by-step explanation:
If government policymakers were worried about the inflationary potential of the economy, the one fiscal policy change that would not be correct would be D. Increase the budget deficit. This is because an increase in the budget deficit typically involves either increasing government spending or decreasing taxes, both of which can lead to an increase in aggregate demand, potentially fueling inflation.
Now, looking at the Keynesian framework using an AD/AS diagram:
- A tax increase on consumer income would cause consumption to fall, pushing the Aggregate Demand (AD) curve left, and is a possible solution to inflation as it would reduce the inflationary pressure in the economy.
- A surge in military spending would shift the AD curve to the right, which would be a solution during a recession as it increases government spending and boosts aggregate demand.
- A reduction in taxes for businesses that increase investment would also shift the AD curve to the right and is suitable as a recession solution by stimulating investment and economic activity.
- A major increase in what the U.S. government spends on healthcare could lead to a similar effect as increasing military spending, potentially stimulating aggregate demand during a recession.
Therefore, to combat inflation, the Keynesian response would be contractionary fiscal policy, such as the tax increase mentioned, to shift AD leftward and reduce inflationary pressures while maintaining full employment.